Written by Bogdan Pavliuk, Senior Consultant
The financial crisis of 2008 uncovered several fundamental systemic risks in the global financial system. Among them, one of the most concerning was the interconnectedness of market players in the over-the-counter (OTC) derivatives market. The crippling financial losses that materialised due to the interwoven web of interest rate and credit derivative trades going sour brought to the focus the importance of counterparty credit risk (CCR) management. This triggered an industry and regulatory push towards managing and limiting CCR, including through improved central clearing rules and increased margin requirements (i.e., collateralisation) for OTC derivative transactions.
Furthermore, the crisis exposed the striking level of undercapitalisation in the banking sector, as evidenced through the failings of major global banks. This, in turn, highlighted the need for regulators to rework the regulatory framework governing the minimum capital requirements for banking institutions, particularly regarding the calculation rules for OTC derivative exposures. As a result, the Basel Committee on Banking Supervision (BCBS) published in March 2014 a consultation paper on the revised “Standardised Approach to Counterparty Credit Risk” (SA-CCR). Intended to resolve the issues with the prior regulatory capital framework for CCR, the new approach has been rolled out as part of the Basel III post-crisis reforms. It remains largely unchanged in the upcoming Basel IV package.
Based on the original publication by the BCBS, the European Commission issued in November 2016 a legislative proposal on revisions to Reg. EU 575/2013 (i.e., the revised Capital Requirements Regulation – CRR2), which embeds in the EU legislation, inter alia, the SA-CCR. The consolidated CRR2 was subsequently published in the Official Journal of the European Union (OJ) in June 2019, with the SA-CCR provisions coming into force on the 28th of June 2021.
The aim of the SA-CCR has been to replace the previous non-internal model approaches, namely the “Current Exposure Method” (CEM) and the “Standardised Method” (SM) used to quantify the exposure at default (EAD) for CCR under the Basel framework. The latter means that the SA-CCR is applicable to all banks that do not have approval for the “Internal Model Method” (IMM), with the scope covering OTC derivatives, exchange-traded derivatives, and long settlement transactions.
In addition to addressing the deficiencies of the CEM and SM, the primary objectives of the SA-CCR, according to the BCBS, include devising a standardised approach that:
Besides being the default approach for non-IMM banks, the introduction of the Basel IV “output floor” will also require institutions with internal CCR models to compute risk-weighted asset (RWA) amounts as per the SA-CCR. Moreover, the SA-CCR exposure metric will feed into other core risk management areas of the Basel framework, including the leverage ratio calculation. Thus, the SA-CCR is a topic of significant relevance for all banks engaged in derivatives transactions. Having a thorough understanding of the approach and its key risk drivers is essential to establishing successful risk and capital management frameworks.
At its core, the EAD as per the SA-CCR is comprised of two components: the replacement cost (RC) and potential future exposure (PFE). Mathematically, the calculation is expressed as follows:
where α is a constant scaling factor set at 1.4 (consistent with the IMM).
Replacement cost (RC):
The RC component reflects the immediate loss that would occur if the counterparty were to default and the trades closed out (i.e., the current exposure). In simple terms, the RC is calculated as the total mark-to-market (MtM) of the derivative trades at the netting set level, less collateral. The RC is floored at zero. However, the exact calculation depends on whether the trade is subject to a margin agreement related to the exchange of a variation margin.
Potential future exposure (PFE):
The PFE component intends to capture the potential increase in the derivative exposure in the future (e.g., due to fluctuations in market factors) and consists of two elements:
While the RC is computed at the netting set level, the PFE add-ons are more computationally intensive and are calculated for each regulatory asset class within a given netting set and subsequently aggregated to the total PFE add-on for the same netting set. Each asset class is in turn subdivided into different hedging sets, whereby the latter represent groups of transactions within or across which full or partial offsetting (i.e., hedging) is permitted.
The add-on calculations for each of the regulatory asset classes follow distinct rules, summarised in the following table:
Interest rate (IR)
Hedging sets are defined per currency (e.g., EUR, USD, JPY, etc.) and further subdivided per maturity bucket:
Full offsetting between long and short positions is allowed within the same hedging set and maturity bucket, while only partial offsetting is recognised across maturity buckets.
Foreign exchange (FX)
Hedging sets are defined per currency pair (e.g., FX derivatives referencing EUR/USD and USD/EUR belong to the same hedging set). Full offsetting between long and short positions is allowed for the same currency pair, while offsetting across different currency pairs is not recognised.
Credit spread (CS)
Hedging sets are defined per entity (or index) referenced by the credit derivative. Full offsetting between long and short positions is allowed for the same entity (or index), while only partial offsetting is recognised across different entities (or indices).
Similar to the CS asset class, hedging sets are defined per entity (or index) referenced by the equity derivative. Full offsetting between long and short positions is allowed for the same entity (or index), while only partial offsetting is recognised across different entities (or indices).
Hedging sets are defined per commodity category and further subdivided per commodity type (the latter must be defined by the institution such that basis risk is minimized):
Full offsetting between long and short positions is allowed for the same commodity type, while only partial offsetting is recognised across different commodity types within the same commodity category. Offsetting between commodity categories is not permitted.
While allocating a vanilla derivative to a given asset class is generally straightforward, this may not be the case for more complex/hybrid trades that embed multiple risk drivers. According to the regulation, the mapping should be based on the primary risk driver of each derivative transaction, if available (e.g., the primary risk driver of an equity option is the underlying equity). All material risk drivers should be identified if there is no single risk driver. Beyond this generic requirement, neither the Basel nor the CRR2 standards provide further guidance.
As a result, in December 2019, the EBA published a final draft RTS “on mapping of derivative transactions to risk categories” (EBA-RTS-2019-02), outlining a three-pronged method:
With the SA-CCR differing substantially from the prior non-internal methods, there is significant work to be done by institutions to comply with the new regulatory requirements while minimizing the EAD (and by extension RWA) impacts on their derivative portfolios. The main effects can be split into those of a more operational versus strategic nature.
On the operational side, the main challenges and considerations relate to the implementation and streamlining of the SA-CCR calculations, including the following:
The strategic challenges and considerations include, but are not limited to:
In addition to offering an off-the-shelf SA-CCR calculation tool (see the next section), Finalyse has the experience and expertise to guide all impacted institutions in their journeys towards SA-CCR compliance.
Finalyse offers a simple, intuitive and user-friendly Excel-based calculator for the calculation of the EAD amounts according to the latest regulatory rules under the SA-CCR. Based on the user’s inputs (trade-level and netting set-level data), the calculator can automatically perform the following:
Thanks to its flexibility, the Finalyse SA-CCR calculator can be used as a means to efficiently validate other SA-CCR calculation engines, or as the institution’s designated tool for regulatory reporting.